Canadian Pacific Gains 37% as China Beats Rail Margins: Real M&A

Shareholder losses are transforming Canadian Pacific Railway Ltd. (CP), the least efficient railroad in North America, into a takeover candidate with the promise of a 37 percent payoff.

Shares of the rail operator, which hauls coal, grain and fertilizer bound for China across six Canadian provinces and 13 U.S. states, are “undervalued and are an attractive investment,” according to activist hedge-fund manager William Ackman, who bought a 12.2 percent stake and intends to hold talks with management. Canadian Pacific was the only railroad to suffer losses in the past year as rivals gained 18 percent.

Even after bad weather in western Canada and the industry’s highest operating expenses versus sales made Canadian Pacific less profitable than any other North American railroad, it may still attract interest from Warren Buffett and Canadian pension funds, according to IHS Global Insight and Caldwell Securities Ltd. While Ackman said yesterday that he’s not pushing for a sale, Canadian Pacific could ultimately get as much as C$85 a share in a takeover, Highmark Capital Management Inc. said.

“There’s huge value to these assets and they’re underutilized and underperforming,” Todd Lowenstein, a money manager who helps oversee about $16 billion at Highmark Capital, said in a telephone interview from Los Angeles. “Vultures tend to circle when your stock’s been an underperformer. It’s kind of standing out as the ugly duckling. There’s an opportunity for margin enhancement.”

Photographer: Don MacKinnon/Bloomberg

A Canadian Pacific Railway engine sits in a railyard in Port Coquitlam, British Columbia, Canada. Close

A Canadian Pacific Railway engine sits in a railyard in Port Coquitlam, British Columbia, Canada.

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Photographer: Don MacKinnon/Bloomberg

A Canadian Pacific Railway engine sits in a railyard in Port Coquitlam, British Columbia, Canada.

Avalanches, Mudslides

Ackman, who runs New York-based Pershing Square Capital Management LP, said in a telephone interview yesterday that Canadian Pacific “is not a case where we’re pushing to sell the company.” He declined to comment on what his strategy would be for the Calgary-based rail operator.

Ed Greenberg, a spokesman for Canadian Pacific, declined to comment on whether it is considering a sale.

Canadian Pacific climbed 0.2 percent to C$62.37 in Toronto today. The shares closed at C$62.22 yesterday, 6.7 percent less than its price a year ago. The nation’s second-largest railroad has lagged behind its biggest competitors even after rebounding in October with its largest ever monthly gain.

Among so-called Class 1 freight rail operators in North America, or those with $250 million or more in annual operating revenue after adjusting for inflation, Kansas City Southern (KSU) had the biggest advance with a 42 percent gain in the past 12 months. Canadian National Railway Co. (CNR), the country’s largest operator, climbed 19 percent, data compiled by Bloomberg show.

Operating Expenses

Canadian Pacific’s earnings have been hurt as extreme snow and rain that caused avalanches, mudslides and flooding in parts of Canada and the U.S. snarled some of its 14,800 miles of rail operations, according to Brian Yarbrough, a St. Louis-based analyst with Edward Jones & Co.

Net income declined in each of the last three quarters -- with its first-quarter profit slumping by the most in seven years -- because of higher operating costs as Canadian Pacific had to reroute shipments onto other railways and spend more on fuel for the weather-related detours.

The additional costs left its operating ratio, or how much of its sales are used to cover operating expenses, at 75.8 percent last quarter, the highest proportion among its largest competitors, data compiled by Bloomberg show.

Canadian Pacific’s trailing 12-month profit margin of 10.6 percent was also the lowest in the group, the data show.

‘Through the Mountains’

“The weather was very bad this year in western Canada,” John Kinsey, a Toronto-based fund manager for Caldwell Securities, which oversees C$1 billion ($980 million) in assets, said in a telephone interview. “It was very rainy and affected the Canadian Pacific lines going through the mountains. That interrupted travel time.”

One day after shares of Canadian Pacific slumped to an almost two-year low on Sept. 22 amid the profit slump, Pershing Square, Ackman’s $10 billion hedge fund firm, began buying the stock, according to a regulatory filing disclosed last week.

The 45-year-old money manager, who invests in companies he deems undervalued and then urges changes he says will boost returns, is now Canadian Pacific’s biggest stockholder with more than 20 million shares including options.

The disclosure of Ackman’s stake sparked speculation that Canadian Pacific may now face pressure to sell some or all of itself. In the past year, Pershing Square has bought stakes of more than 10 percent in Fortune Brands Inc., the maker of Jim Beam bourbon now know as Beam Inc. after a spinoff, and J.C. Penney Co., the third-largest U.S. department store chain.

Edward Jones’ Yarbrough said that Ackman is interested in Canadian Pacific because “there’s a lot of upside to the earnings” if the company can lower its operating ratio.

Buffett, Bakken Shale

“That means a lot of earnings power over the next few years and that’s where the bull case lies,” he said.

Buffett could be a potential buyer, according to Charles Clowdis, managing director of transportation advisory services at forecaster IHS Global Insight in Lexington, Massachusetts.

The 81-year-old billionaire investor and chairman of Berkshire Hathaway Inc. (BRK/A) spent $26.5 billion in 2010 to buy Fort Worth, Texas-based railroad Burlington Northern Santa Fe in his largest purchase. Buffett didn’t respond to a request for comment e-mailed to his assistant, Carrie Kizer.

Acquiring Canadian Pacific would give Burlington Northern access to the Bakken shale oil formation centered in North Dakota, according to IHS Global’s Clowdis.

“It makes a lot of sense” for Burlington Northern and Buffett, Clowdis said in a telephone interview. Canadian Pacific “would fill them out nicely,” he said.

‘Commodity Play’

Energy companies are pursuing unconventional oil assets such as Bakken shale as the cost for finding and developing the fuel for the largest U.S. producers surged more than sixfold in the past decade, data compiled by Bloomberg show.

In 2000, Burlington Northern scrapped a plan to merge with Canadian National Railway after the carriers decided they couldn’t wait for the U.S. to lift a moratorium on rail deals.

Canadian Pacific may also lure a consortium of Canadian pensions, according to Caldwell Securities’ Kinsey. Such a group may have an easier time winning regulatory approval than a non- Canadian buyer, he said.

The Canadian government rejected Melbourne-based BHP Billiton Ltd.’s $40 billion hostile takeover of Saskatoon, Saskatchewan-based Potash Corp. of Saskatchewan a year ago after the province said the sale would cut jobs and tax revenue.

Canadian Pacific would be an attractive asset because its shipments of metallurgical coal, an ingredient used in steelmaking, for delivery to Asia are poised to increase.

Exports of metallurgical coal from Canada are estimated to climb 38 percent by 2015, driven by demand from China, the world’s fastest growing major economy, according to an Oct. 4 report from Credit Suisse Group AG.

“They’re a great commodity play,” Lee Klaskow, an analyst with Bloomberg Industries in Skillman, New Jersey, said in a telephone interview. “They haul grain. They haul coal. They haul sulfur and fertilizer. It’s a play on exporting to its trading partners in the U.S. and obviously going off to Asia.”

To contact the reporters on this story: Tara Lachapelle in New York at tlachapelle@bloomberg.net; Natalie Doss in New York at ndoss@bloomberg.net.

To contact the editors responsible for this story: Daniel Hauck at dhauck1@bloomberg.net; Katherine Snyder at ksnyder@bloomberg.net; Ed Dufner at edufner@bloomberg.net.

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